Mid-cap and small-cap indices, which have outperformed in recent years could underperform the large caps, or even yield a negative return this year, said H Nemkumar , head, IIFL Institutional Equities . In an interview with Sanam Mirchandani on the sidelines of the IIFL Global Investors’ Conference, Nemkumar said the period of low volatility is over and the market may see much higher volatility going forward.

Edited excerpts:

Indian markets have fallen sharply from record highs. How should investors play this market now? Markets, unlike last year, will remain volatile this year. The PE multiple on a trailing basis is at a record high. The market is pricing in a lot of growth and that cost of capital will remain benign. If one of these hypotheses is tested, then markets will come under pressure. The global economy is doing very well. There is uncertainty on the inflation side as a consequence of the bond markets. Now, bond markets are reasonably well behaved, in 3% range (US 10-year yield) and it will be still fine. If there is a bond market sell-off, then that will spill over to equities. The period of low volatility is now behind us. Volatility will be much higher going forward.

What are the key challenges for the Indian markets? The challenge is that while valuations have seen a big re-rating, earnings growth momentum has not seen acceleration. While we have seen big earnings downgrades in the last three years led by high NPL provisioning, for example, some of that has slowly started to change, particularly in commodity companies. There has been a big shift in the earnings trajectory but that is not true of all sectors. In aggregate, there are some sectors which are still pulling down, such as PSU banks. If you look at cement, there is a downward shift in earnings. In telecom, we have seen continued downgrades. On an aggregate, we have not seen any positive earnings coming. Last year, there was a belief that because of all the reforms, earnings will revive. If for one more quarter, if we don’t see earnings revival come through, then this market will possibly come under pressure. We will have to give it three-four months more time as to how GST stabilises etc. I am hopeful that earnings will revive and FY19 will be a good year in terms of growth. There will be better clarity after three months or so. If one has an equity portfolio, try good quality names at this point and stay away from just cheap value plays.

Mid and small-cap stocks have fallen sharply. What is your strategy? Mid-caps and small-caps will underperform large-caps this year. You have to be even more choosy when you own midcaps. The probability is high that valuation will see a de-rating for all these companies. In the broad rally that we saw in the past 12 months, you could have owned any midcap stock. In some cases, you would have made 50% and in some cases you would have made 100%. That will not happen this year.

What is your return expectation for this year? Midcap indices may actually yield even a negative return this year. As far as large-cap indices are concerned, at least in the very near term, depending upon how the state election outcomes come, we may again see a bit of volatility. But moderate single digit returns is kind of the best one can expect at this point this year.

Which are the sectors which you are overweight and underweight on? We are very positive on software, we like some of the midcap names. We like the private banks, particularly retailoriented banks. We like select NBFCs. We also like large capital good proxies because the capex cycle is now turning up. Utilities is one sector where there is deep value. We are also very bullish on downstream oil PSUs. Other than these, most other sectors we are neutral or negative.

LTCG on equity was reintroduced and Indian exchanges recently said they will stop providing data to foreign exchanges. Has that affected sentiment towards India? Trading costs in India have become much higher and that is a source of friction. In aggregate, they are even higher than the brokerage that is charged to customers. Particularly for ETFs, LTCG is an irritant. Investors are ok paying a tax. It becomes slightly more difficult in terms of accounting for NAVs etc because from 1st April they have to account for potential capital gains tax that they have to pay and there will be a one-time adjustment in NAV that will have to happen. LTCG tax is not as big an issue. So far as feed not being given is concerned, one of the agencies that provide benchmark indices has issued a press statement that this is a withdrawal of liquidity and to that extent they will examine whether India should be treated as a peripheral market. But, it is not so simple. They will have to examine this in detail. Alternate solutions are being worked out. We should not jump to any conclusions right now, rather wait. Two or three months down the road, this may get resolved.